‘Creative Destruction’ in 2018

The Great Disruption. The end of one year and start of the next is the perfect time to reflect and resolve to change for the better.

At the start of this year, the most popular resolutions involved the typical fare: the desire to get healthy, get organized, live life to the fullest, learn a new hobby, spend less or save more, travel and read more.

Philosophers like to wax poetic about change. Nuggets of wisdom include: “The only thing that is constant is change.” There’s also: “The more things change the more they stay the same.” And for the deep thinkers in the crowd: “No man ever steps in the same river twice, for it’s not the same river and he’s not the same man.” Thank you, Heraclitus.

Change—and the resulting disruption—has buffeted many S&P 500 industries this year. Sometimes, the change began many years ago, but momentum seemed to pick up and reach a tipping point this year.

For example, the Internet has been widely used for almost two decades, but this year, hundreds of bricks and mortar retailers shut their doors as competition from Internet and off-price retailers caused the likes of Sears, Macy’s, and others to shrink in bid for survival.

Likewise, the battery has been around since the 1800s, but improvements in energy storage are making solar and wind energy generation viable alternatives to gas- and coal-powered electric plants. Batteries may also be on the verge of driving major changes in transportation. Blockchain, artificial intelligence, and genetic engineering may be new advancements, but there’s no doubting they will shake up the status quo for years to come.

Jackie and I have been writing about the Great Disruption during most of 2017. Let’s review some of this year’s biggest disruptions as we’re about to start a new year:

(1) The Internet. We’ve been surfing the ‘net for almost 20 years now, but people are still figuring out ways to use it to change just about everything. Book, electronic, and clothing retailers have been facing intense competition—and shuttering storefronts—for years. But 2017 will go down as the year store closures accelerated despite a strong economy and competition invaded the grocery aisles.

Deborah Weinswig, an analyst at Fung Global Retail & Technology, tracks announcements of the openings and closures of a set number of US retailers. She reports that closure announcements increased by 229% ytd in 2017, bringing the total number of stores to be closed to 6,985. The most recent casualty: Charming Charlie, which sells inexpensive jewelry and novelty items, filed for bankruptcy protection and announced plans to shut 100 of its roughly 370 stores by yearend.

Competition in the grocery business hit a frenzied pitch this year as Amazon acquired Whole Foods in August, following Walmart’s purchase of Jet.com in September 2016. Throw in the US expansion of German grocers Aldi and Lidl, and you’ve got an intensely competitive market that has kept a lid on consumers’ food prices and squeezed margins.

“Higher prices for vegetables, beef and eggs helped push the food portion of the producer-price index up 3.5% annually in November, according to the Labor Department. Meanwhile consumers paid just 0.6% more for groceries that month than a year earlier, the department said on Wednesday. The spread between producer and retail prices is the widest in more than three years,” a 12/17 WSJarticle reported, referring to data from Barclays.

The disruption has also put pressure on food companies, leading many of them into marriages. The latest deals were announced this week: Campbell Soup plans a $6.1 billion acquisition of Snyder’s-Lance, and Hershey offered $1.6 billion to buy Amplify Snack Brands.

Investors should be aware that both industries have P/E multiples near 15-year highs. The Internet Retail industry, which also contains highflier Netflix, is expected to grow earnings 37.0% over the next 12 months, but boasts a 71.8 forward P/E (Fig. 3 and Fig. 4). The Hypermarkets & Super Centers industry is only expected to grow earnings by 6.9% over the next 12 months, which makes its forward P/E of 23.2 look equally pricy (Fig. 5 and Fig. 6).

Meanwhile, the S&P 500 Food Retail industry, with Kroger its sole constituent, has fallen 0.3% ytd, and the S&P 500 Packaged Foods & Meats industry has lost 0.8% ytd (Fig. 7 and Fig. 8). The Food Retail industry has a much lower forward P/E of 13.5, but its earnings are forecasted to fall by 2.5% over the next 12 months (Fig. 9 and Fig. 10). The Packaged Foods industry’s forward earnings are expected to grow 7.1%; however, its forward P/E is 18.0 (Fig. 11 and Fig. 12). Maybe it’s time to stay away from all of the above until valuations—or growth prospects—look more attractive.

(2) Certainly entertaining. Streaming television shows and movies over the Internet to televisions, computers, and cell phones existed in years past, but 2017 seemed to be the year that hit shows from Netflix and Amazon attracted large enough audiences to make even the industry’s titans take notice.

Disney’s $52.4 billion acquisition of 21st Century Fox’s assets was undoubtedly a reaction to changes in the industry. The deal gives Disney more content to stream directly to customers, instead of relying on Netflix for distribution. The added heft should also help Disney in future negotiations about the distribution of its content with cable and wireless companies now that the Trump administration has rolled back net neutrality.

Change has not been kind to the S&P 500 Movies & Entertainment index, which is up only 5.1% ytd. With Disney, Fox, Time Warner, and Viacom as members, the industry has suffered from downward earnings revisions, and it’s expected to grow earnings by 6.5% over the next 12 months (Fig. 13 and Fig. 14). However, not much enthusiasm is priced into the shares now that the industry’s forward multiple has fallen to 15.3 (Fig. 15).

The S&P 500 Cable & Satellite industry index has fared better, returning 12.8% ytd, while the S&P 500 Broadcasting stock price index has fared worse, falling 5.2% ytd. Despite fears of losing eyeballs, the Broadcasting industry is expected to grow earnings by 10.9% over the next 12 months and has a forward P/E of only 11.4 (Fig. 16 and Fig. 17). Meanwhile, the forward P/E of the S&P 500 Cable & Satellite industry, at 21.6, is lofty relative to its expected forward earnings growth of 12.8% (Fig. 18 and Fig. 19).

(3) Old dog, new tricks. The lowly battery is having a renaissance. The ability to make more powerful batteries that can last longer has meant they can now be used to power cars and trucks and to store vast quantities of power generated by wind and solar farms. The developments have had wide impact on the auto industry, utilities, GE, Siemens, and even commodities.

Elon Musk is, of course, the poster child for the battery’s evolution, renowned for his Gigafactory in the Nevada desert and Tesla cars. Despite the company’s lack of profits, Tesla’s stock is up 58.6% ytd, dwarfing GM’s 21.0% advance and Ford’s 4.4% gain.

The S&P 500 Automobile Manufacturers (Ford and GM) index is up 12.9% ytd, and while it has a forward P/E of only 7.5, earnings are expected to fall by 10.5% over the next 12 months (Fig. 20 and Fig. 21). In this cyclical industry, a low P/E may indicate peak earnings.

The use of batteries to store electricity made by solar and wind farms has reduced the need to build new electric plants. And as we discussed in the 11/28 Morning Briefing, fewer plants has meant less demand for the giant generators produced by GE and Siemens. However, it has also meant increased demand for lithium. One of the largest producers of lithium, Albemarle, has seen its shares climb 53.4% ytd, which has helped push the S&P 500 Specialty Chemicals industry stock index up 31.0% ytd (Fig. 22).

(4) Building on blockchain. While we haven’t been fans of bitcoin or other cryptocurrencies, we have tracked with interest the many new uses that various industries are finding for blockchain, the system that tracks cryptocurrencies transactions. Transactions are monitored by multiple computers so that data can be tracked, verified, and hopefully not hacked. Multiple users can safely access data that is constantly updated.

Cargill is testing blockchain as a way to track turkeys as they move from the farm to the grocery store, a 10/25 WSJ article reports. The food industry hopes using blockchain will help it improve food safety and reduce waste. The real estate industry is evaluating how to use blockchain to record property titles.

Some of the highest hopes for the technology are centered on using it in the financial industry. It could be used to track the clearing and settlement of many different types of loans and securities. “In the US, DTCC is working with IBM, R3 and Axoni to shift post-trade clearing of single-name credit default swaps on to a blockchain system by the end of next year. If this goes well, the plan is to do the same with other derivatives processed by the giant US clearing house,” reported a 10/16 FTarticle.

Central banks could shift their payments systems onto blockchain or use it as the foundation for their own cryptocurrencies, the FT article continued. Blockchain could be used in trade finance, the verification of customers, and loan syndication. The rollout of this new technology undoubtedly will hurt some businesses, causing layoffs in some areas, but also will cut costs and create new jobs in other areas.

This is by no means an exhaustive list of the changes that we’ve tracked this year or that we expect to follow in the coming months. Artificial intelligence, robots, and genetic engineering appear to be in the first inning of fascinating nine-inning games. May 2018 contain plenty of changes that make all of our lives better and provide many investment opportunities.